So this week is a bit of a continuation of our post from two weeks ago about the state of the Venture Funding scene and some of the tailwinds we are seeing in the data and what they could be signaling for the industry. This week we are taking a closer look at an interesting correlation that we read about in a recent blog from Repoint partner, Tom Tunguz.
The post is titled, "The Figures that Will Move the Venture Capital Market in the Next 5 Years". And one graph that Tom shares right at the beginning of the post jumps right off the screen:
A lot has been made of inflation over the last few months as we come out of the last year and a half of lock-downs and restriction dues to the COVID-19 pandemic. From the graph above we can see a strong parabolic correlation between 10-Year Federal Treasury Bond rates and the total $ of venture capital invested. We can in the data that around 2010 are rates approached 2% and then ultimately when below 2, the total value of venture $ goes parabolic, peaking at over $2T in total investment in 2020.
For those of you not familiar with the Venture Capital ecosystem, a quick primer on why this relationship exists. LPs, or Limited Partners, are the entities that provide capital to VC funds. Limited Partners often are large institutional investors such as a pension fund, large corporation, or mutual fund. These are pools of billions of dollars and capital typically fueled by retirement savings and investments from tens to hundreds of thousands of individuals. To put it in perspective, the 5 largest pension funds in the world hold over $6T in capital. These institutions invest that money in a variety of asset classes to help grow the principal holdings of the individuals who have retirement or other savings invested with them.
Treasury Bonds are a major source of returns and part of the overall asset allocation strategy for, go back to 2000, when rates were 6% meaning that these large capital pools could purchase these bonds and essentially guarantee a 6% return over the 10 year period when the government pays back the bond. Not the world's biggest returns, but about as safe as it gets in terms of their fiduciary duty to their client base.
Now obviously purchasing treasury bonds is a part of a larger overall investment strategy for these large institutional investors, but as the 2000s rolled on and then into the 2010s, those treasury rates kept dropping. Venture Capital is another part of that overall allocation strategy. Venture is a far riskier asset class that when deployed correctly by professional funds managers, can produce tremendous returns. As the rate of federal treasury bonds drops, their risk-reward profile becomes more in-line with venture so ultimately the allocators of these massive chunks of capital start to shift capital from being allocated into these treasury bonds towards something with a greater return potential, such as venture capital. And it worked, kinda:
Above is a breakdown of the net cash flow from the VC industry over the last 20 years and we can see over the last 10 years, as those bond rates fell, contributions have kinda grown, though the percentage has remained fairly consistent, what really picked up was the distributions (return of capital) to LPs which picked up drastically over the last decade (2010–2019) versus the pace of 2000–2010. Now is that a product of the lower interest rates? Venture Capital is a long return game, often taking 8–12 years to see returns on a successful investment so the majority of that net positive cash flow and distributions for LPs were on investments made during that pre-2010 ramp up in venture capital invested as the fed rate dropped.
Two weeks ago we wrote about how over the last 10 years ( you can read the post here), coinciding with the drop in rates and as venture funding became more and more available, the terms in which that capital has been invested by venture GPs has increasingly favored founders. Better valuations, larger rounds, and a rollback of liquidation preferences and investor protections have made the last 10 years quite a time to be a founder and startup employee. But is it a healthier environment overall? The answer really is time will tell.
We probably won’t have a firm answer for this question from another 10 years or so, 2030 will be the bell-weather to look back and see if the funding environment from 2010–2020, which has been hot as we can see from the graph from the Tom Tunguz article, but will it continue to perform? There is also the massive question around whether or not The Fed will increase rates and pour some cold water on the available capital flowing into venture markets.
But the big question will be how will the next generation of startups perform? Will net cashflows to LPs remain positive if rates don’t increase and venture dollars continue to flow, sure there will be more startup than ever receiving financing, but will the returns stay where they are, or are these decades returns a product of a much tighter and more disciplined investing environment of the previous decade? The other big question will be, what happens to the venture industry if fed rates do start to increase over the next handful of years?
With record numbers of capital invested, funds raised, and new funds formed, what happens to the market if capital availability cools off with a rate increase? It’s hard to say for sure, but there is a concern that with such massive exposure as a market if capital availability dries up it will most likely take down some funds and startup with it. Those not yet profitable and already having raised on massive valuations won’t have as easy a time finding new funds, funds exposed to these starts will feel the pressure as port co’s fail and ultimately weigh on the funds’ performance.
What we find fascinating about the data and the industry is that performance and outcomes take so long to materialize, it's hard to really say what is causing a trend. Sure The number looks great the last 10 years, with plenty of capital contributions, new funds, and net cash flow back to LPs. Is that a reflection of the current state of the venture market or are these the outcomes driven by a decade in which capital was tighter? Tunguz talks about in his post how the venture scene tends to be slow to react to market forces changing, even if fed rates do increase it could be a few years before we see that reflected in the number of dollars contributed to Venture Funds by LPs. All of this is to say it's complicated haha. This is a complicated market with a huge number of forces that impact it yet the tailwinds take years to play out given that typically we are talking about companies that are about as early in their life as you can get so their maturity and their investor's outcomes are a ways off.